How I’m Using Dollar Cost Averaging – For Better Or For Worse

As I mentioned earlier, I recently bought into the Vanguard 500 using part of my emergency fund. Since then, I’ve set up a monthly deposit into that fund, intending mostly to focus on building up the balance to a sufficient level. The real purpose of the fund is to enable my wife and I to do some interesting things when our children leave for college, such as quitting our “normal” jobs and focusing on public service at the local level.

What I realized is that using an automated investment system amounts to dollar cost averaging. By doing it this way, I’m basically committing myself to a dollar cost averaging approach to my investment.

If you’re unfamilar with dollar cost averaging, it’s an investment philosophy that involves you buying into a particular investment over time with an equal amount of cash each time. When the investment’s value is high, you don’t get as many shares; when it’s low, you get more shares. Over time, this can reduce the pain of a down market. Essentially, because of my monthly investment plan, I’m now doing dollar cost averaging into the Vanguard 500, buying the same dollar amount in shares each month and riding it through the ups and downs.

Here’s the question: is this a good thing? Lots of financial advisors think that dollar cost averaging is the cat’s banana, but I’m not entirely convinced. Let’s look at a year in which the value of a stock starts at 100, goes up 10 a month until June (the peak), then stays steady for the rest of the year. You paid $134.94 per share with dollar cost averaging. If you instead bought in at the start of the year with your complete investment, then you paid only $100 per share.

On the other hand, let’s look at the reverse market: the stock starts at 100, goes down 10 a month until June, then stays steady the rest of the year. If you invested it all right off the bat, you spent $100 a share for stocks now worth $50, but if you used dollar cost averaging on a monthly basis, you only paid an average of $58.66 per share.

Dollar cost averaging is good if you think there’s a good chance that the market will see turbulence or go down. It will reduce the impact of the collapse on your investing. On the other hand, dollar cost averaging doesn’t do so well if the market is going crazy.

Since I think the market is going to be turbulent, but not go up or down a whole lot overall in 2007, I think that dollar cost averaging is fine for me in the short term.

If you have cash on hand, it’s generally better to invest it all at once rather than dollar-cost averaging. If you’re investing it as you get it, though, that’s good. John Allen Paulos’ book, _A Mathematician Plays the Stock Market_, gives an analysis with these conclusions.

I’ve not read it, but Ben Stein and Phil DeMuth wrote a book called _Yes, You Can Time the Market_ which suggests a variant of dollar-cost averaging, using the 15-year moving average of various indicators to determine whether or not to invest (in an S&P index fund) in any given month. From what I’ve read, I think their strategy suffers from the usual problems of back-testing, and is not likely to be more effective going forward than dollar-cost averaging.

I recommend Burton Malkiel’s _A Random Walk Down Wall Street_ and Paulos’ book over Stein and DeMuth’s.

You need to read Against the Gods: the remarkable story of Risk by Peter Bernstein. This book is about the history of probability theory, the insurance industry and the stock market. The smartest mathematicians and economists in the world keep getting closer, but making huge mistakes. You can’t predict the market, you can only look at what has happened in the past, and try to hedge.

The simple bottom line is buy low and sell high, but that’s the opposite of personal behavior: when your mutual fund starts to go low, many people want to sell it and when it goes higher, many people want to buy more. Dollar cost averaging is buying low and buying fewer high. It’s a smart way to invest, you’re doing the right thing.

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